Myth: It is Hard to 'Buy Low, Sell High'

The Word on the Street

Everybody knows that they always want to buy when prices are low. And not just when investing! And everybody knows the they want to sell when prices are high. Again, not just when investing! But so many people lose tons of money on the stock market because they do the opposite: they sell low and buy high. Since so few people can actually buy low and sell high, it must be hard to know when to buy and when to sell.

The Truth

Buying low and selling high is VERY easy for anyone to do. There is a trick to investing called “Dollar Cost Averaging” that will ensure that you always follow this good rule of thumb.

Doubt me? Read on and see the magic of dollar cost averaging.

What is Dollar Cost Averaging?

Dollar cost averaging is not easy to define, but is easy to illustrate. And since I am a numbers guy, I am going to use math to demonstrate:

Let’s compare two scenarios:

Bob saves his money with his bank until he has a sizable chunk of money to invest in his stocks A, B, and C. Jill regularly puts in a consistent amount of money into the same stocks as Bob. Suppose they both put in $120 over 3 months, and the stocks fluctuate according to the following table:

Dollar Cost Averaging 1

Bob puts in all $120 in month 1, and gets 4 shares of A, 6.15 shares of B, and 3.63 shares of C, and he holds them for all 3 months.

Jill, instead, puts in $40 a month, split evenly between all three stocks. So she buys shares according to the following table:

Dollar Cost Averaging 2

At the end of month 3, They both have invested $120. So where do they stand? Shouldn’t they be the same because they bought the same stocks over the same time period? Let’s see.

Dollar Cost Averaging 3

Jill has more shares than Bob. How? She bought MORE when they were cheap, when the price went down. Because she invested regularly rather than in a lump, her dollars bought more shares of cheap stocks and less of the stocks whose price had gone up! Without even trying, she bought low. That’s dollar cost averaging. Sounds great, but how effective is it really? At the end of month 3, if Bob and Jill were to both sell their stocks, Bob would receive $102.81, 14% less than he invested because the stock prices all went down. If Jill sold her shares, she would receive $122.96. that’s a 3% gain! But how is it possible? The stock prices went down, didn’t they?!

The key lies in the regularly scheduled purchases. When stock B dropped in month 2, she bought over 4 shares of it. Then, when the market went back up, the value of the shares she bought while the stock was low GAINED in value. The difference between the lump-sum investment that Bob made and the dollar-cost averaging strategy used by Jill is a positive 17%! So, if you use the dollar cost averaging strategy, you will automatically buy more of the stocks that are low, and when you sell, you will have greater gains (usually) than you would have otherwise. No expertise or experience required!

Posted on 3 Jan 2008